Title

Presentation

Operator: Good day, and welcome to the Diversified Healthcare Trust Fourth Quarter 2022 Earnings Conference Call. All participants will be in a listen only mode . Please note, this event is being recorded. I would now like to turn the conference over to Melissa McCarthy, Manager of Investor Relations. Please go ahead.

Melissa McCarthy: Good morning. And welcome to Diversified Healthcare Trust call covering the fourth quarter 2022 results. Joining me on today’s call are Jennifer Francis, President and Chief Executive Officer; and Rick Siedel, Chief Financial Officer and Treasurer. Today’s call includes a presentation by management, followed by a question-and-answer session. I would like to note that the transcription, recording and retransmission of today’s conference call are strictly prohibited without the prior written consent of Diversified Healthcare Trust or DHC. Today’s conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based upon DHC’s current beliefs and expectations as of today, Thursday, March 2, 2023.

The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today’s conference call, other than through the filings with the Securities and Exchange Commission, or SEC. In addition, this call may contain non-GAAP numbers, including normalized funds from operations or normalized FFO, EBITDA, net operating income, or NOI, and cash basis net operating income or cash basis NOI. Reconciliations of net income or loss attributable to common shareholders to these non-GAAP figures and the components to calculate AFFO, CAD or FAD, are available in our supplemental operating and financial data package found on our Web site at www.dhcreit.com. Actual results may differ materially from those projected in any forward-looking statements.

Additional information concerning factors that could cause those differences is contained in our filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements. As we’ve previously disclosed in February, we agreed to tender all of the Aleris Life Inc. common shares we currently own in connection with the tender offer and proposed acquisition of AlerisLife Inc. by ABP Acquisition, LLC. In light of the pendency of the tender offer, we do not intend to speak to these matters on today’s call and instead refer you to our current report on Form 8-K we filed with the SEC on February 2, 2023 and to the offer to purchase filed by AlerisLife Inc. with the SEC on February 17, 2023, for additional information.

Now I’d like to turn the call over to Jennifer.

Jennifer Francis: Thank you, Melissa, and good morning. Thank you for joining us on today’s fourth quarter and year end 2022 conference call. 2022 was a year of recovery for Diversified Healthcare Trust, as we executed on our plan to deploy capital across our portfolio and support the operators and asset managers that are implementing the recovery strategy in our senior living communities. All of our operators have been successful in growing occupancy and revenue during the year, while they worked diligently to battle inflationary pressures that are impacting labor, utilities, food and other expenses across our portfolio. Rick and I will provide details this morning on some of their successes and also on some of the challenges still to overcome in the year ahead.

After market closed yesterday, DHC reported normalized FFO of $0.03 per share for the fourth quarter. The year-over-year and quarter-over-quarter improvement in normalized FFO from negative $0.07 per share and negative $0.06 per share, respectively, was largely driven by continued improvements in three areas within our SHOP segment during the fourth quarter; first, growth in net operating income and operating leverage for the quarter and the year; second, an acceleration in occupancy recovery and rate growth during the quarter; and third, a decrease from the third quarter in the use of contract labor and the associated costs. Starting with the positive trends in our SHOP segment. Many of our metrics are trending positively, but most notably, occupancy improved 380 basis points year-over-year to 76.3% and same property occupancy also increased 380 basis points year-over-year to 76.7%.

We’re continuing a consistent trend of improvement as this is our seventh consecutive quarter of occupancy growth in this segment as we saw a 180 basis point increase in occupancy from the last quarter in our same property occupancy and a 160 basis point increase over the last quarter in our consolidated portfolio. Our transitioned communities achieved a year-over-year occupancy increase of 660 basis points. Similar to the overall senior living industry, the recovery in our SHOP segment was led by our needs based assisted living communities, which were hard hit during the pandemic due to the impact that COVID-19 had on high acuity seniors in assisted living and by the fact that occupancy in these communities was trending lower prior to the pandemic as the assisted living sector had experienced more oversupply than independent living.

Occupancy improvements have been bolstered by our operators’ improved marketing and sales processes and by the positive impact of our ongoing capital investment strategy. We believe that continued focus in these areas will yield further improved performance. We’re encouraged by the quarter’s progress in occupancy, but we believe there is still room for improvement across this segment. SHOP revenue increased $33 million year-over-year or 14% and 3.5% since the last quarter. These increases in revenue were driven primarily by higher rental and care revenue and reduced discounts, a direct result of the sales training that has been implemented by all of our operators. Average monthly rates increased nearly 9% year-over-year as our operators are pushing rate across the board.

While this occupancy and revenue growth are encouraging, elevated expenses in our SHOP segment remain a challenge. This quarter’s property level operating expenses increased by close to $19 million or 8% from last year. They decreased by close to 2% sequentially, though, as operators began to see certain expenses moderate. For instance, contract labor and utilities declined compared to the third quarter, but remained elevated year-over-year. Our operators experienced less pressure on wages during the quarter with agency usage down significantly from the third quarter, although, there’s still improvement needed in our communities with skilled nursing units. Our operators remain very focused on employee recruitment and retention. Recruitment efforts include the use of dedicated hiring specialists, careful evaluation of competitive wages and the more frequent use of sign-on bonuses.

Retention efforts center on paying competitive wages to existing employees, active employee engagement, consistent career path development and generally fostering a strong workplace culture within their teams. While the cost and availability of labor remains a challenge in this industry, the recruitment and retention of nurses remains the greatest staffing challenge for our operators. We’ve made significant progress with our planned renovation projects and our managed senior living communities. We’ve added a page to our supplemental package that highlights and provides detail on our development projects in our SHOP segment. Renovation projects were completed at 36 of our communities in 2022. In 2023, we’re in active stages of planning or construction for renovations at 89 communities, and we anticipate approximately 70% of these projects will be completed by year end.

As I’ve said in the past, we believe that our capital spend in communities is an important part of the turnaround underway in this segment. Turning to our office portfolio segment. Year-over-year rental income was up slightly in our same property office portfolio, but fourth quarter cash basis NOI was down slightly by 90 basis points due to a number of onetime expenses across our portfolio. For leasing activity, we executed 182,000 square feet of new and renewal leases in the quarter, with strong roll-up in rents of 8.9% and a weighted average lease term of 9.2 years. We ended the quarter at 90% occupancy in our same property office portfolio segment and had a leasing pipeline of just over 1 million square feet at year end, in line with our pipeline in the third quarter.

We have just over 110,000 square feet of transactions in our pipeline where leases have been signed or are in letter of intent stage with leases being negotiated. I’d like to speak briefly about our wellness centers, which accounted for 3.6% of our fourth quarter NOI. In January, we terminated the leases of a tenant of three wellness centers located in Tampa, Atlanta and the suburban D.C. area. These are extremely well located properties in affluent submarkets. Subsequent to termination, we have a signed lease for one of the locations and have a signed letter of intent for the two other clubs. Also in February, we announced that we had amended our credit facility to provide DHC covenant relief while we continue to execute on our recovery strategy this year.

I’ll now turn the call over to Rick, who will provide more detail on our financial results and the key terms of this amendment. Rick?

Rick Siedel: Thanks, Jennifer, and good morning, everyone. For the fourth quarter, we reported normalized FFO of $0.03 per share. Adjusted EBITDA for the fourth quarter was $59.7 million, up $23.9 million or 67% from the third quarter. Our consolidated cash basis NOI increased approximately $18.9 million from the third quarter with growth in each of our segments. Cash NOI from our SHOP segment increased $13.6 million while our office portfolio segment increased $3.5 million or 12.3%, and our triple net leased senior living communities and wellness centers increased $1.8 million or 21.5%. These increases were partly attributable to certain events specific to the quarter. First, in our SHOP segment, we recognized an insurance recovery of $3.6 million related to expenses recognized in the third quarter due to Hurricane Ian.

In our triple net leased senior living communities and wellness centers, we recognized $3 million of percentage rent as we do each year during the fourth quarter, which was partially offset by an $800,000 decrease in cash NOI related to the wellness center default that Jennifer just discussed. Finally, we recognized a lease termination benefit of $3 million related to one of our office redevelopment projects when we had the opportunity to negotiate a favorable termination as the tenant was at risk of default. I’ll next provide additional detail on our SHOP segment performance that I believe illustrates the work we and our operators have ahead of us and the opportunity for the portfolio. Our total SHOP NOI for the fourth quarter of $7.9 million included 119 communities operating with 11,582 units that had negative NOI totaling $18.7 million or NOI margins of negative 16%.

Approximately 44 of these communities have occupancies over 75% and will focus on growing rates and controlling expenses to return to profitability. The remaining 75 communities will focus on occupancy, rate and expense control as part of their business plan. We also had 111 communities with 13,764 units that produced positive NOI of $27.2 million. Average NOI margin in these communities was 18%, which included 23 communities that were below 75% occupied. We expect to see margin expansion as these communities bring in additional residents and are better able to leverage fixed cost as occupancy increases. We also expect our operators to continue to push rates and expand margins in our communities with stabilized occupancies as we continue to face inflationary cost pressures.

General and administrative expenses decreased $2.8 million or approximately 33% from a year ago and $415,000 from the third quarter as a result of our lower management fees. Our managers business management fees continue to be calculated based on our market capitalization and not on the historical cost of our assets, which resulted in a reduced fee paid to RMR in the fourth quarter, which, when annualized, equates to a $21 million reduction. Interest and other income of $9.2 million for the quarter included $3.2 million of income from government grants and relief programs related to the pandemic. Interest expense of $49.3 million for the fourth quarter represented a 22% reduction from a year ago, but an increase of approximately $2.5 million or 5% from the third quarter as a result of higher interest rates on our floating rate credit facility.

In October, we repaid a mortgage note on a life science property for approximately $10 million. And as Jennifer mentioned, in February, we announced an amendment to our credit facility. This amendment provides us with fixed charge coverage ratio covenant relief into 2024, while our SHOP segment recovers and allows us flexibility to continue investing in our portfolio to accelerate that recovery. The amendment also reduced the minimum liquidity requirement from $200 million to $100 million. In exchange, we have paid down the facility to $450 million, have agreed to a 40 basis point increase in the interest rate and no longer have the ability to reborrow funds. Our credit facility is secured by mortgages recorded on 61 medical office and life science properties.

These properties totaling 5.3 million square feet are located in 21 states, including Washington, D.C. We’re approximately 90% occupied and generated $18.7 million of cash basis NOI in the fourth quarter. At year end, we had total outstanding debt of $3.1 billion and net debt of $2.4 billion was equal to just 30.6% of gross assets. We have no significant maturities until 2024, and we have over $5.8 billion of unencumbered gross real estate assets. As we’ve previously said, investing in our portfolio is a priority for us and we continue to execute on plans to improve our properties to grow occupancy, push rental rates and enhance the overall value of the portfolio. In the fourth quarter, we spent $118.6 million on capital expenditures across the portfolio, which included $99.4 million of capital improvements and redevelopment within our SHOP segment.

That concludes our prepared remarks. Operator, please open up the line for questions.

See also 25 Best Countries to Start a Business and 17 Most Valuable Furniture Companies.

Operator: The first question comes from Joshua Dennerlein from Bank of America.

Joshua Dennerlein: Just kind of curious how you guys are thinking about the SHOP recovery going forward? And then maybe I know you’ve done some CapEx to the properties, like additional CapEx you might want to put in, and if there’s any additional kind of — you mentioned sales training that the operators are putting in place. Like any kind of additional initiatives that might kind of help get that kind of kicking up higher going forward?

Jennifer Francis: I think that the operators, the training in marketing and sales is really having an impact. The other thing that they’re — I mean, one of the other things they’re focused on is making sure that their leads are qualified leads. We’ve spent a lot of time talking about growth in leads over the past couple of years. And instead of thinking about the number of leads, they’re extremely focused on making sure that the leads that they do spend time on are qualified leads so that we then have higher conversion rate, that’s just one of the many things. I mean there are improvements across the board that they’re focused on. As far as the capital, we will continue to spend capital in this portfolio this year and next.

It’s been extremely well received by the residents and the communities and by the employees. And it just makes the quality of the employee experience and the resident experience better. And so we have some great projects in the queue, in the coming two years.

Joshua Dennerlein: Is there any way you can kind of quantify the spend on that additional kind of CapEx you’re planning properties over the next two years?

Jennifer Francis: Sure. Rick?

Rick Siedel: So we spent a little over $300 million in 2022 and about $228 million of it was in the SHOP portfolio. We expect it to continue kind of at that level for 2023 as well. We do have some flexibility and can be pretty nimble in adjusting which projects are moving forward at which time. A lot of the planning is done and we’re really getting to the execution phase, which is great. But I would say that SHOP portfolio likely to get about $225 million or so in 2023. And then I guess we’ll see how the results come out. But I expect to see some really great returns on that cost throughout the portfolio, generally in the high teens, low 20% returns. So we’ll have the ability to pivot them into 2024 but it will really depend on what the cost of capital looks like and everything else. But it should be — we’re really excited about the potential growth in the portfolio.

Operator: The next question comes from Bryan Maher with B. Riley.

Bryan Maher: And sorry if I missed any of this, my call got dropped for a moment. But on the SHOP rates up 8.9% year-over-year, a little bit higher than what we were expecting. Can you give us a little bit of your thoughts on how you think that, that plays out over 2023? I know you guys don’t guide, but maybe some commentary on the momentum there.

Jennifer Francis: Our operators are pushing rate across the board, and we’ll continue to do so with — everybody sees what’s going on with inflation and cost increases. So there’s really — there’s a good story in pushing rate. In addition, some of the sales training that we talked about or that we’ve been talking about is also sales training for having those difficult conversations with the residents and families of the residents about pushing rate and overcoming objections. So it’s not just sales to the outside, but it’s also sales training on defending rate increases. So we expect to see similar increases in the coming year.

Bryan Maher: And I don’t know if you’re comfortable commenting on this, but you’ve had pretty good momentum on the occupancy side lately. I know that you look at trade rags and what have you, and some of your competitors, they talk about 1Q typically being a little bit seasonally weaker. But do you think that, that puts a kink at all in the current momentum you have?

Rick Siedel: I don’t think so. I mean traditionally, Q4 and Q1 are a little slower, but we were able to kind of beat the trend in Q4 and January was trending pretty well. So no.

Jennifer Francis: And I think we’ll continue. We’re expecting to have similar momentum.

Bryan Maher: And then maybe one more for me before I hop back in the queue for Rick. I know that the big bogey out there is the second half trying to get to that incurrence covenant at 1.5. I know that there’s some noise in the numbers because you just paid down the facility, $250 million or so. But even looking at the 4Q over 3Q momentum in net debt-to-EBITDA metrics, which improved hugely and EBITDA to interest expense, again, improved hugely, can you give us any flavor on how you’re thinking about the incurrence test?

Operator: It appears we have lost connection with our speakers, please hold while we reconnect. . We currently have Bryan Maher on the question queue.

Bryan Maher: I don’t know if you guys heard my question or not. Can you hear me now?

Jennifer Francis: Yes, we can. And Bryan, we did and apologize, our line went dead so we quickly called back in. I think Rick is prepared to answer your question.

Bryan Maher: Great. Because my e-mail lit up as soon as you guys dropped off.

Rick Siedel: So I think the question, just to recap is basically when — how close are we to the 1.5 times debt incurrence test so that we can refinance and operate like like normal. So you probably noticed we reported in the supplemental on a trailing 12 months basis that consolidated income available for debt service over debt service was about 0.83 times. If you adjust that for the acquisition that we did and the couple of properties that we’ve sold along with the debt paydowns that have happened, kind of on a pro forma basis for that we’re at about 1.04 right now. And that leaves us with needing to improve NOI by about $74 million to get back to compliance. So we do believe there’s a path there. The question as far as when is a difficult one to answer.

There are a lot of moving variables. But we think we’re executing on the right plan, again, investing in the SHOP portfolio, while also very focused on managing them operationally is we think the recipe for success to get back there. This number is only about 53% of where the portfolio used to perform back in 2019. So we think it’s achievable. We just need to actually execute on it now. So that’s where all of our focus is.

Bryan Maher: And just to be clear, I mean, in our model, we have you getting there by year end. We’ll see how that plays out, but the trends are clearly moving in the right direction. But maybe you can just talk to briefly, and then I’ll hop back in the queue, kind of plans B and C if that weren’t to happen? I mean you continue to talk about $5.8 billion in unencumbered assets. I would suspect that you could sell some or JV some to kind of get where you need to be for 2024, if push came to shove?

Jennifer Francis: There are a couple of levers. You’re correct that we could — we have some great MOB and life sciences assets that many investors are interested in. So whether it was a disposition, more likely a JV. The other thing is our capital spend, while we believe that the capital spend is pretty important, we’ve planned it in a way that it’s being done in phases so that we — some of our — or many of our large capital projects are broken up into Phase I, Phase II, Phase III. So we can get through Phase I and then assess whether we continue on to Phase II, and then, again, Phase III. So we do have the ability to regularly think about the projection of that capital spend.

Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Jennifer Francis, President and Chief Executive Officer, for any closing remarks.

Jennifer Francis: Thank you, and thanks to everyone for joining our call today. Operator, that concludes our call.

Operator: The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.